Well that escalated quickly! 2018 has been a torrid year for most financial assets as they try to adjust to the last decade’s dominant monetary policy regime – Quantitative Easing – reversing direction towards a more “normal” setting. From the usual suspects of emerging markets and equities, right through to the traditionally more staid investment grade credit and government bond markets, 2018 has set records for being uniquely bad for capital markets. According to recent research by Deutsche Bank, some 89% of asset classes had posted negative Year-To-Date returns (in USD terms) to the end of October – the highest proportion ever recorded, stretching back to 1901.
To the surprise of many, one area which has performed remarkably well has been the high yield market. This would seem at odds with most people’s perception of the asset class; with its fixed income and equity-like characteristics coupled with increased market volatility looking like a recipe for disaster in the current climate. This is not to say that the asset class has not become ‘cheaper’ in the turmoil; indeed the yield on the global high yield index has increased from 5.25% at the start of 2018, to around 6.6% at the end of October.
What has allowed high yield to stay in the black is the often overlooked, and enduring power of carry. Whilst an equity’s valuation is dominated by the net-present-value of far-off (and often theoretical) cash flows; high yield takes a more certain view of equity-like returns and insists on cash up front via high, contracted, semi-annual coupons. Similarly, lower yielding fixed income instruments (in government and investment grade markets) have levels of carry often unable to fully compensate for the capital swings that changes in the underlying rate environment entail. The high yield carry allows the asset class to adjust more quickly to changes in the yield environment, a process further assisted by its relatively low duration of around four years.
High yield is often described as halfway between traditional bond and equity risk, with the negatives of each often emphasised. In times like the present however, with an uncertain interest rate outlook, low defaults, and moderate but increasing inflation, it offer investors a little of the best of both and we would urge investors to take a closer look.